As­set al­lo­ca­tion in the era of cheap oil

We’ve read plenty of bullish state­ments re­cently say­ing that the de­cline in oil prices amounts to a mas­sive tax cut; “a phe­nom­e­non that’s mak­ing every­body bet­ter off,” as US Fed­eral Re­serve vice chair­man Stan­ley Fis­cher de­clared last week. But as Fred­eric Bas­tiat wrote, in eco­nomics you have what you see and what you don’t see, or as Mil­ton Friedman put it: “There is no such thing as a free lunch.”

Let us as­sume that the world is con­sum­ing 92mln bar­rels of oil a day and car­ries 100 days of inventory. At US$100/bbl, the value of the cap­i­tal tied up in in­ven­to­ries would be US$92 mln x US$100 x 100, or US$920 bln. If the price of oil falls to US$50, fi­nanc­ing those in­ven­to­ries will cost US$460 bln in­stead of US$920 bln, which means that the slump in the oil price would be equiv­a­lent to the re­lease of US$460 bln of liq­uid­ity into the sys­tem.

Now, a change in the price of any prod­uct com­pared with other prod­ucts is al­ways a change in rel­a­tive prices. This un­der­lines a sim­ple re­al­ity: the de­cline in oil prices is sim­ply a trans­fer of pur­chas­ing power from the pro­duc­ers of oil to its con­sumers. There is no ad­di­tional wealth cre­ated when prices go up or down—none at all. The only things that mat­ters are the fol­low­ing:

1) Somebody in the sys­tem has to take the US$460 bln loss on in­ven­to­ries—and they have to take it now. Dur­ing the last big de­cline in en­ergy prices start­ing in 1985, the loss was borne first by Texas (in 1988 alone, 175 Texan banks went bust) and later by the Soviet Union, which went un­der at the end of the decade. The same sort of thing is go­ing to hap­pen this time around. The im­por­tant thing is not to be caught among the losers. Un­for­tu­nately, that’s eas­ier said than done.

2) The val­u­a­tion of long du­ra­tion oil-pro­duc­ing ca­pac­ity should not be af­fected too much by the de­cline in oil prices, in so far as a present value anal­y­sis of ex­ist­ing re­serves will be favourably im­pacted by the re­cent de­cline in long rates and un­favourably im­pacted by the fall in oil prices. That’s not so for short du­ra­tion ca­pac­ity. As a re­sult, the de­cline is good for Saudi Ara­bia and Rus­sia, and bad for the US.

3) Over the last few years, we have had a mas­sive ex­pan­sion in oil-pro­duc­ing ca­pac­ity, for ex­am­ple in US shale gas and oil. The ques­tion is: How much of that ex­pan­sion has been fi­nanced by debt? And if a lot, then by what kind of debt? If the ex­pan­sion has been fi­nanced by cor­po­rate bonds, then the knock-on ef­fect of de­faults will be limited. But if it has been fi­nanced by bank loans, there could be big prob­lems. Con­cep­tu­ally, the losses in­curred by banks on th­ese loans could erode their cap­i­tal and so lead to a big re­duc­tion in their abil­ity to lend. In that case, the dam­age could can­cel out the pos­i­tive ‘liq­uid­ity’ ef­fect of the de­cline in the value of oil in­ven­to­ries.

4) Is the propen­sity to con­sume of the oil con­sumer higher than the propen­sity to con­sume of the oil pro­ducer? If the an­swer is yes, we will see an in­crease in global con­sump­tion and a de­crease in the global sav­ings rate. In that case, the de­cline in oil prices should lead first to a fall in in­ter­est rates (be­cause of the liq­uid­ity ef­fect) and once the oil price sta­bilises, to a rise in long term rates. Thus, the para­dox­i­cal im­pact of a big de­cline in oil prices could be a rise in in­ter­est rates, as a re­sult of the de­cline in the gen­eral sav­ings rate. What is cer­tain is that the propen­sity to con­sume of the poorer half of the US pop­u­la­tion is very high. So a de­cline in oil prices should be good news for the US lumpen­pro­le­tariat. The re­sult­ing in­crease in con­sump­tion could lead to a re­newed de­te­ri­o­ra­tion in the US cur­rent ac­count.

5) If the price of oil falls abruptly, the pain is usu­ally felt in a very con­cen­trated area, while the ben­e­fits are dif­fused much more widely. More­over, the pain hits quickly while the ben­e­fits spread rel­a­tively slowly. Con­cen­trated pains tend at­tract a lot more at­ten­tion from the do-good­ers pos­ing as politi­cians than dif­fused ben­e­fits. This is usu­ally when mis­takes are made.

To sum­marise: On the liq­uid­ity side, the re­lease of liq­uid­ity from oil in­ven­to­ries is a plus; the po­ten­tial con­trac­tion of banks’ lend­ing abil­i­ties is a mi­nus.

On the eco­nomic ac­tiv­ity side, the ben­e­fi­cia­ries of cheap oil have a higher propen­sity to con­sume, which is pos­i­tive; how­ever, cap­i­tal spend­ing could go down im­me­di­ately, which is neg­a­tive. So, what in­vest­ment con­clu­sions can we draw from all this? Long-dated US gov­ern­ment bonds are now slightly over­bought and over­val­ued. If 30-year long rates were to fall from 2.9% where they are to­day to 2.5 %, which is the bot­tom of my val­u­a­tion range for the 30-year, then main­tain­ing a bal­anced port­fo­lio would cease to make much sense.

When it comes to the stock mar­kets, as long as the US cur­rent ac­count was im­prov­ing, I main­tained that one should con­tinue to hold shares in the US. If the fall in oil prices leads to a re­newed de­te­ri­o­ra­tion of the US cur­rent ac­count, then one should buy stocks out­side the US, where eq­ui­ties are al­ready at the bot­tom of their long term trad­ing range com­pared with US stocks.

As a re­sult, the fall in oil prices could, and should, lead to a mas­sive shift in as­set al­lo­ca­tion, from US to non-US eq­ui­ties, and into shorter du­ra­tion bonds.